Wednesday, January 28, 2009

Stimulus, Part I: Why Obama's Stimulus Package Won't Work

Mr. Obama is indeed correct that the country is at a "perilous moment." The only problem is that, sincere as we assume the president to be, his proposed economic stimulus package will only increase the peril of the moment, to say nothing of wrecking the future.

As I understand it, the whole idea behind Mr. Obama's proposed stimulus package (as of this writing not yet enacted into law) is that the federal government — meaning the taxpayer — will 1) provide funds to help unsuccessful gamblers and speculators recover the money they lost, so they can gamble and speculate again in the vague hope that their doing so will result in some kind of investment that creates jobs, thereby increasing effective demand, 2) provide funds to consumers who presently lack sufficient income to provide sufficient effective demand to keep the economy going, increasing demand and creating jobs, and 3) increase government spending on public works and infrastructure, thereby creating jobs and increasing effective demand.

In the Keynesian universe, the purpose of production is not consumption, but to provide jobs that will generate effective demand. Thus, the basic assumptions underlying Mr. Obama's Keynesian — one might say ultra-Keynesian — approach to economic recovery are 1) increased demand for consumer goods follows increases in capital investment, 2) production for consumption is not necessary, 3) capital investment can only take place by first cutting consumption, then investing, and 4) production does not equal income.

In a Keynesian universe, investors can only form capital when 1) effective demand has been reduced by saving, 2) there is no need for new capital formation other than to create jobs needed to 3) provide wage income to purchase existing goods and services, thereby 4) replacing the funds previously diverted to investment.

Within the Keynesian framework, then, all that should be necessary to stimulate the economy is to 1) create money to replace what was previously diverted to savings, thereby 2) increasing effective demand, 3) clearing existing excess production, and 4) creating jobs to provide income to increase effective demand.

The flaws in the Keynesian program should be obvious. 1) If consumers are simply lent money to increase effective demand, they must at some future time decrease effective demand by the same amount in order to repay the loan, plus reduce future effective demand further by whatever interest rate, risk premium, and service fee is added to the original loan principal. Thus, allowing people to borrow money to finance consumption is worse than self-defeating. It is (not to put too fine a point on it) economic insanity. Because the consumer must pay back more than he or she borrowed, future effective demand is reduced at a greater rate than it was originally increased by the extension of consumer credit. The problem of excess production due to decreased effective demand is worse, and more people lose their jobs in consequence.

2) If a business borrows money for capital formation that results in job creation when there is insufficient effective demand in the economy to justify the investment (a given in Keynesian economics due to Keynes' fixed belief that consumption must be reduced in order to finance capital formation), the business will require a taxpayer subsidy in order to make a profit and stay in business.

a) If the subsidy is provided out of tax collections, effective demand is further reduced, and the business will require increased subsidies to make up for the reduction in effective demand.

b) If the State provides the subsidy by monetizing its deficit (i.e., printing money backed by debt to be repaid by future taxpayers), the resulting inflation will decrease effective demand as the price level increases, again making additional subsidies necessary (whether you call them subsidies, price supports, bailouts, or stimulus packages) in order to make a profit and stay in business.

Either method results in a vicious circle of inflation to overproduction, overproduction to unemployment, unemployment to increased government spending, and increased government spending back to inflation. This is the trap we are in now, with Mr. Obama's stimulus package virtually custom designed to add gasoline to the fire, making the problem infinitely worse.